April 14, 2004 4:00 AM PDT

The rise of Sun services

Sun Microsystems CEO Scott McNealy often chides rivals for solving customers' problems by using lots of people rather than smart technology, but Sun's own services unit has quietly become a crucial revenue contributor.

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What's new:
Despite CEO Scott McNealy's disdain for big services groups, Sun's own unit has quietly become important to the company's bottom line.

Bottom line:
In order for Sun's services division to maintain its momentum, it must continue to avoid straying into partners' territory, and new chief Marissa Peterson must prove a worthy successor to Pat Sueltz.

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Revenue from services accounted for nearly a third of all revenue for the company's 2003 fiscal year, and the business posted a significant operating income compared with an overall loss for the company. As a result, investors will likely be focused on the performance of the unit when Sun reports third-quarter results Thursday, results expected to come in at a loss of 7 cents per share.

Jonathan Eunice, analyst with researcher Illuminata, said services are vital because companies increasingly want a complete package from technology providers, including help in managing complex computer systems. "I don't think it's in the Sun religion," Eunice said, "but services are a key part of the solution."

Sun attributes the division's success partly to a new focus on preventative customer care rather than the traditional "break-fix" model. The company also has been trying to strengthen its relationships with partner companies.

But there is evidence of stress within the unit that could stall its growth, such as the recent departure of Pat Sueltz, services chief and architect of these partner efforts. In addition, tensions may rise with Sun's partners over its increased service offerings, creating additional challenges for the company as it tries to turn around its overall fortunes--Sun has weathered 11 straight quarters of declining revenue on a year-over-year basis.

Service with a smiley
Information technology services range from hardware maintenance contracts to advice on setting up computer systems to full-scale outsourcing. Such operations are playing a more prominent role at most large tech companies.

IBM Global Services, for example, accounted for nearly 50 percent of the company's $89.1 billion in revenue last year. Hewlett-Packard's services wing made up just 16.4 percent of the company's revenue in the most recent quarter. But HP Services has landed some prominent deals in the past year or so and recently joined IBM and others in the market for so-called business process outsourcing services, which involve taking over tasks such as human resources or procurement.

At 11,000 employees, Sun's services unit is far smaller than IBM's (about 180,000 people) and HP's (roughly 65,000). It hasn't made any moves into the business outsourcing arena. And while IBM and HP eagerly go after information technology outsourcing deals, Sun prefers to help customers run their own IT shops, or to let another IT services company take on the work.

Still, services comprised between 27 percent and 36 percent of total revenue during the past few quarters. The services unit posted record revenue of $3.6 billion in the year ended June 30, 2003, up 7 percent from the previous year. This growth occurred as overall revenue at Sun fell 8.5 percent year-over-year to $11.4 billion.

Sun reported operating income of $1.19 billion for its services unit in the year ended June 30, 2003, compared with an overall operating loss of $2.7 billion.

Historically, IT services units have had lower profit margins than software or hardware operations. In its most recent quarter, for example, Sun's gross margin in services was 39.3 percent, while gross margin in products was 43.1 percent. Sun had been reluctant to expand its services precisely because of this issue, according to a former company executive.

Despite the growth of Sun's services unit, McNealy still refuses to define Sun as a services company. To him, the services division is closely tied to Sun's primary focus on selling technology, although the company is determined to increase its "recurring" revenue.

"We think it's all part of being a systems company," he said in a recent interview. McNealy also reiterated his view that concentrating on the automation of tasks is the best strategy for solving an IT problem. "We don't think you can win by throwing bodies at it," he said.

Even so, Sun is using its employees to handle a broader range of tasks for clients. Before Sueltz took over Sun Services in mid-2002, the unit concentrated to a large degree on fixing problems arising with customers' gear. Under her guidance, Sun began developing a "lifecycle" methodology that involves helping customers avoid problems in the first place by helping them design their computer systems, implement the technology and manage it.

Sun's managed services business, which the company launched last year, is focused on making Sun gear easier to operate, including areas such as business continuity and capacity management. The company offers services to update patches, as well as design-related services to ensure that servers are more reliable by having consistent software configurations.

Another part of the new services thrust is collecting data on how Sun equipment performs. Through its so-called "knowledge services," Sun analyzes this information to come up with optimal data center configurations and to predict potential problems.

Tom Kucharvy, analyst at Summit Strategies, said most of Sun's services revenue growth comes from maintenance fees on installed equipment. But, he said, a growing amount stems from predictive and managed services.

Sun's focus on more advanced services scored a hit recently with Major League Baseball. In late March, Sun and MLB Advanced Media, the interactive media company of Major League Baseball, said they had extended a technology alliance for an additional two years. Sun said its services unit would design and build a data center infrastructure based on its hardware, software and blueprint for managing digital files. To date, Sun said, it has worked with MLB Advanced Media to create a Web site that delivers streaming video of up to 15 live games daily.

"After evaluating the other logical choices, we felt Sun was the only company that could handle the magnitude and scope of MLBAM's business to support baseball's extensive 2,430 games per year, compared to the NFL with only 250 games," Bob Bowman, CEO of MLB Advanced Media, said in a statement.

As part of its new services push, Sun has also been teaming with other IT services companies. In February, the company launched a security services product with VeriSign. Last year, Sun announced a utility computing arrangement with Affiliated Computer Services, through which Affiliated will deliver applications built on Sun gear. Sun announced a similar deal in October with IT services company SchlumbergerSema to offer outsourced server services.

Risk factors
Even as it tries to nurture closer ties with partners, though, Sun's expanded services threaten to step on their toes. System integrators like Affiliated Computer Services make their living partly through the sort of consulting work Sun is beginning to embrace. "Sun's expansion in services is going to push up against the business of their partners," Eunice said.

But he added that Sun remained less aggressive in services than its rivals in the systems business, HP and IBM. Kucharvy agreed. "Of the three major Unix system vendors, they have clearly taken the most partner-centered strategy."

Marissa Peterson, who replaced Sueltz as the unit's chief, said Sun is working to keep its partners happy even as it widens its role. "We know they have got to make money," she said. "We're very sensitive to that."

So far, Sun appears to have been able to thread the needle.

Johnnia Vanderbly, director of strategic partnerships and alliances for AT&T Business, suggested Sun has steered clear of AT&T's bread-and-butter services, making the two quite compatible as partners.

"The work we're doing with Sun is very complementary," Vanderbly said. "They sell hardware and we sell networking and communications services." Sun recently announced that it, AT&T and Nortel Networks will work to upgrade the Chicago Tribune Company's technology for greater security and reliability.

Sun also seems to be avoiding conflicts with partners in the mid-size business arena. BlueStar Solutions uses Sun gear as it provides services such as hosting business management software to companies in the midmarket. Ellen McGinnis, BlueStar senior alliance manager, said Sun's services unit generally stays out of BlueStar's way. "We haven't really run into them all that much," she said. "It's not like IBM. BCS (IBM's Business Consulting Services division) tries to swim downstream a little more."

Still, there are questions about leadership at Sun Services. Sueltz left Sun in February to take a post at Salesforce.com, a provider of customer relationship management services. Her departure followed the loss of Vivek Joshi, the former vice president of marketing and strategy for Sun Services, who left the company several months ago.

Kucharvy called Sueltz a "strong executive," but did not view the departures with alarm. "Sun has enough management depth that it can certainly find people."

Peterson has been at Sun for 16 years and has served as chief customer advocate and executive vice president for worldwide operations. She will continue to hold those roles while taking on the title of executive vice president of Sun Services.

Such multitasking raises a red flag for Eunice. "It seems to me that that's three jobs," he said. "It's very hard for people to do three jobs."

Peterson pledges she will spend most of her time on the services business. She also said she has strong help with the operations and customer advocacy divisions. Overall, she said would continue the push that Sueltz began in terms of preventative services and higher-level consulting. "We're staying the course," she said.

That course is not a groundbreaking one, according to Sun rival HP. HP has offered higher-level, "mission critical" services focused on preventing problems for many years, said Dan Socci, HP vice president for customer support. "We're a little surprised that (Sun wasn't) doing more of this earlier."

Even so, Illuminata's Eunice sees potential in Sun's revamped services unit. He said new products from Sun, such as the company's new software package for desktop computers, should open the door to even more service revenue in areas such as product workflow assistance. Eunice sees services revenue climbing further as a share of total revenue at Sun, reaching "40 percent or beyond."

 

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